Transfer Payments:
Welfare and Social Security
Part I
The tyranny of a prince in an oligarchy is
not so dangerous to the public welfare as
the apathy of a citizen in a democracy.
Charles de Montesquieu
Major Transfer Programs

Roughly 50 cents out of every dollar is devoted
to transfer payments.
◦ Transfer payments – payments to individuals
for which no current goods or services are
exchanged, such as Social Security benefits
Cash vs. In-Kind Benefits

Income transfer doesn’t always entail cash
payments.
◦ In-kind transfers are direct transfers of goods
and services rather than cash.
◦ Cash transfers are income transfers that
entail direct cash payments to recipients.
Cash vs. In-Kind Benefits

Examples of in-kind transfers include food
stamps, Medicaid benefits and housing subsidies.

Examples of cash transfers include Social
Security, welfare and unemployment benefits.
Cash vs. In-Kind Benefits

Target efficiency is the percentage of income
transfers that go to the intended recipients and
purposes.

The target efficiency of a transfer program tells
us how well the transfers attain their intended
purpose.
Chart: Income Transfer Programs
TANF 2%
Social
Security
46%
SSI 3%
EITC 3%
Food stamps 2%
Housing aid 2%
Unemployment insurance 3%
Other 3%
Medicaid
13%
Medicare
24%
Social Insurance vs. Welfare

Not all income transfers go to the poor.
◦ A lot of student loans go to middle-class
college students.
◦ Disaster relief helps rebuild both mansions
and trailer parks.
Social Insurance vs. Welfare

Medicaid is an in-kind welfare program.

Welfare programs – means-tested income
transfer programs, examples include welfare and
food stamps
Social Insurance vs. Welfare

Social Security and Medicare social insurance
programs are not welfare programs because
recipients don’t have to be poor.

To get Social Security or Medicare benefits, you
just have to be old enough and have paid into
the program while you worked.
Social Insurance vs. Welfare

Social insurance programs are eventconditioned income transfers intended to
reduce the costs of specific problems.

Most income transfers are for social insurance
programs, not welfare.
Social Insurance vs. Welfare
WELFARE
Food Stamps
TANF
SSI
Housing Aid
Child Nutrition
Medicaid
SOCIAL INSURANCE
Social Security
Medicare
Unemployment
Insurance
Transfer Goals

The basic goal of income transfer programs is
to reduce income inequalities.

The need for government transfers implies that
there has been a failure of the market to
distribute income equitably.
◦ Market failure – an imperfection in the market
mechanism that prevents optimal outcomes
FOR WHOM

Transfer programs significantly change the
distribution of income.

US inequality has been reduced by at least 20%.
WHAT to Produce

Transfer payments also change the mix of
output.
◦ Food stamps increase food consumption.
◦ Housing subsidies increase the demand for
housing.
◦ Student loans increase college enrollments.
Unintended Consequences
Income transfer programs may change market
behavior in unintended ways.
Reduced Output

Transfer payments may dull work incentives,
reducing labor supply and total output.
◦ Labor supply – the willingness and ability to
work specific amounts of time at alternative
wage rates in a given time period, ceteris
paribus
Reduced Output
Attempts to redistribute income may reduce total
income – the economic pie shrinks when we try
to reslice it.
Labor supply with
transfer programs
S2
S1
Labor supply before
transfer programs
Quantity of Labor (hours per year)
Output of Services (units per year)
Wage Rate (dollars per hour)
Charts: Reduced Labor Supply and
Output
Production possibilities . . .
. . . before transfer
programs
. . . with transfer
programs
Output of Goods (units per year)
Undesirable Behavior

People may also change their nonwork behavior.
◦ Welfare benefits encourage recipients to have
more children.
◦ Medicare encourages recipients to overuse
health care services.
◦ Unemployment benefits encourage recipients
to stay unemployed longer.
Welfare Programs

The largest federal cash welfare program is
called Temporary Aid to Needy Families
(TANF).

The TANF program was created by
congressional welfare reforms in 1996 and
replaced an earlier program (AFDC)
Benefit Determination

The first task of the TANF program is to
identify potential recipients.

A four-person family with less than $18,900 of
income in 2004 would have been considered
poor.
Benefit Determination

A family with $16,000 income in 2004, would
have a poverty gap of $2,900.

The poverty gap is the shortfall between actual
income and the poverty threshold.
The Work Incentive Problem

We could just give people a check for the
amount of their poverty gap.

No one would be poor.

This might encourage people who are not poor
to become poor.
The Work Incentive Problem

Families that are already poor have reduced
incentive to work to get out of poverty with
transfer programs in place.

This occurs because the programs are generally
set up to reduce benefits as earned income
increases.
Marginal Tax Rates

When welfare benefits are set equal to the
poverty gap, every additional dollar of wages
reduces welfare benefits by the same amount.

This amounts to a 100% marginal tax rate.
Marginal Tax Rates

Guaranteeing a poverty-level income destroys
the economic incentive of low-income workers
to support themselves.

This creates a moral hazard for welfare
recipients.
◦ Moral hazard – an incentive to engage in
undesirable behavior
Less Compassion

To reduce this moral hazard, Congress and the
states set a much lower ceiling on welfare
benefits.

Rather than closing the poverty gap, states set a
maximum benefit far below the poverty line.
Less Compassion

The formula below for welfare benefits was the
result.

Using this formula, a family totally dependent on
welfare is unquestionably poor.
Welfare = Maximum - wages
benefit
benefit
More Incentives
Another change has been made in the benefit
formula to encourage welfare recipients to lift
their own incomes above the poverty line.
More Incentives

The implicit marginal tax rate was cut from
100% to 67%.

So we now have a new benefit formula.
Welfare
M aximum
=
- 2 (wages)
3
benefit
benefit
Chart: Work (Dis) Incentives
$16000
Total income at 67% rate
Income
12000
8000
G
Total income at 100% rate
A
B
Welfare benefits at 67% rate
4000
Welfare benefits at 100% rate
C
500
1000
1500
Hours Worked (per year)
2000
CONTINUED IN
TRANSFER PAYMENTS:
WELFARE AND SOCIAL SECURITY
PART II